assignment of interest rate cap

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Interest Rate Cap Structure: Definition, Uses, and Examples

What Is an Interest Rate Cap Structure?

An interest rate cap structure refers to the provisions governing interest rate increases on variable-rate credit products. An interest rate cap is a limit on how high an interest rate can rise on variable-rate debt. Interest rate caps can be instituted across all types of variable rate products.

However, interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans.

Key Takeaways

• An interest rate cap is a limit on how high an interest rate can rise on variable rate debt. Interest rate caps are commonly used in variable-rate mortgages and specifically adjustable-rate mortgage (ARM) loans.
• Interest rate caps can have an overall limit on the interest for the loan and also be structured to limit incremental increases in the rate of a loan.

Interest rate caps can give borrowers protection against dramatic rate increases and also provide a ceiling for maximum interest rate costs.

How Interest Rate Caps Work

Interest rate cap structures serve to benefit the borrower in a rising interest rate environment. The caps can also make variable rate interest products more attractive and financially viable for customers.

Variable Rate Interest

Lenders can offer a wide range of variable rate interest products. These products are most profitable for lenders when rates are rising and most attractive for borrowers when rates are falling.

Variable-rate interest products are designed to fluctuate with the changing market environment. Investors in a variable rate interest product will pay an interest rate that is based on an underlying indexed rate plus a margin added to the index rate.

The combination of these two components results in the borrower’s fully indexed rate. Lenders can index the underlying indexed rate to various benchmarks with the most common being their prime rate or a U.S. Treasury rate.

Lenders also set a margin in the underwriting process based on the borrower’s credit profile. A borrower’s fully indexed interest rate will change as the underlying indexed rate fluctuates.

How Interest Rate Caps Can Be Structured

Interest rate caps can take various forms. Lenders have some flexibility in customizing how an interest rate cap might be structured. There can be an overall limit on the interest for the loan. The limit is an interest rate that your loan can never exceed, meaning that no matter how much interest rates rise over the life of the loan, the loan rate will never exceed the predetermined rate limit.

Interest rate caps can also be structured to limit incremental increases in the rate of a loan. An adjustable-rate mortgage (ARM) has a period in which the rate can readjust and increase if mortgage rates rise.

The ARM rate might be set to an index rate plus a few percentage points added by the lender. The interest rate cap structure limits how much a borrower's rate can readjust or move higher during the adjustment period. In other words, the product limits the number of interest rate percentage points the ARM can move higher.

Example of an Interest Rate Cap Structure

Adjustable-rate mortgages have many variations of interest rate cap structures. For example, let's say a borrower is considering a 5-1 ARM, which requires a fixed interest rate for five years followed by a variable interest rate afterward, which resets every 12 months.

With this mortgage product, the borrower is offered a 2-2-5 interest rate cap structure. The interest rate cap structure is broken down as follows:

• The first number refers to the initial incremental increase cap after the fixed-rate period expires. In other words, 2% is the maximum the rate can increase after the fixed-rate period ends in five years. If the fixed-rate was set at 3.5%, the cap on the rate would be 5.5% after the end of the five-year period.
• The second number is a periodic 12-month incremental increase cap meaning that after the five year period has expired, the rate will adjust to current market rates once per year. In this example, the ARM would have a 2% limit for that adjustment. It's quite common that the periodic cap can be identical to the initial cap.
• The third number is the lifetime cap, setting the maximum interest rate ceiling . In this example, the five represents the maximum interest rate increases on the mortgage.

So let's say the fixed rate was 3.5% and the rate was adjusted higher by 2% during the initial incremental increase to a rate of 5.5%. After 12 months, mortgage rates rose to 8%, the loan rate would be adjusted to 7.5% because of the 2% cap for the annual adjustment.

If rates increased by another 2%, the loan would only increase by 1% to 8.5%, because the lifetime cap is five percentage points above the original fixed rate.

Periodic Interest Rate Cap

A periodic interest rate cap refers to the maximum interest rate adjustment allowed during a particular period of an adjustable-rate loan or mortgage.

The periodic rate cap protects the borrower by limiting how much an adjustable-rate mortgage (ARM) product may change or adjust during any single interval. The periodic interest rate cap is just one component of the overall interest rate cap structure.

Limitations of an Interest Rate Cap

The limitations of an interest rate cap structure can depend on the product that a borrower chooses when entering into a mortgage or loan. If interest rates are rising, the rate will adjust higher, and the borrower might have been better off originally entering into a fixed-rate loan.

Although the cap limits the percentage increase, the rates on the loan still increase in a rising rate environment. In other words, borrowers must be able to afford the worst-case scenario rate on the loan if rates rise significantly.

What Are the Disadvantages of an Adjustable-Rate Mortgage?

The disadvantages of an adjustable-rate mortgage include the fact if interest rates rise that your monthly payments could increase to a point where you may not be able to afford them. If you cannot make your mortgage payments, your home is at risk of foreclosure.

Can You Pay Off an ARM Early?

Whether you can pay off an adjustable rate mortgage (ARM) early will depend on the terms of your mortgages. Some lenders allow early payoffs with no penalties, while other will charge a fee if you pay off the loan before the terms ends.

Can You Refi Out of an ARM?

You can refinance an adjustable rate mortgage just as you would a traditional mortgage. You will essentially take out a new loan to pay off the original loan so you will have new terms.

The Bottom Line

Understanding how interest rates caps work with different types of mortgages can help determine with mortgage can best fit your needs. For more specific guidance on your options, consider consulting a professional financial advisor.

Consumer Financial Protection Bureau. " What Are Rates Caps? "

The Federal Reserve Board. " Consumer Handbook on Adjustable Rate Mortgages ."

Freddie Mac. " Considering an Adjustable Rate Mortgage? "

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When the interest rate on a mortgage financing is not fixed, the amount that a borrower may be required to pay may fluctuate depending on changes in the underlying index to which the “margin” or “spread” is tied. While a lender may be comfortable with its underwriting of a financing and the ability of its borrower to service its debt at closing, if the underlying index of a floating rate loan changes over time, the lender’s comfort and the ability of its borrower to service its debt will obviously change. To combat against interest rate volatility, borrowers and lenders usually agree to hedge the interest rate against the uncertainty in the market for floating rate loans. The most common form of such hedging is an “interest rate cap.”

An interest rate cap is a derivative whereby the interest rate cap provider (the “counterparty”) agrees to pay the interest which would be payable by the borrower over a strike price (the “strike”) on the notional amount (the principal amount) of the loan. Consequently, if the index of the loan rises above the strike, the counterparty, and not the borrower, is liable for the excess interest payment obligation. In this way, the borrower’s liability for payment of interest on the loan in question is always “capped” at an amount equal to the strike plus the spread.

As additional collateral for a loan, the borrower will purchase an interest rate cap and pledge it to the lender. Simply put, the interest rate cap is an insurance policy on a floating rate loan, which protects the borrower and the lender if the interest rate index rises above the strike during a specified period of time (the “term”). The term of the cap is usually coterminous with the initial term of the loan. If the loan is extended, extensions are usually conditioned on the purchase of a new interest rate cap for the extended period.

Caps are purchased upfront with a single payment at the closing of a loan. After the premium is paid, the borrower has no further payment obligations. Most lenders will require borrowers to purchase the interest rate cap as a condition to closing the loan. Lenders also require that the cap provider have a minimum credit rating from Moody’s, S&P, Fitch or another rating agency. The interest rate cap is usually auctioned to a number of creditworthy financial institutions to secure the most favorable terms at the lowest premium price. Lenders will require the counterparty to maintain a certain rating level during the term. In the event that the counterparty does not maintain its rating, the borrower will typically be required to (i) replace the counterparty with a new counterparty that meets the qualifications and execute a new interest rate protection agreement, (ii) require the counterparty to supply a guaranty from a party meeting the ratings default, or (iii) cause the counterparty to deliver collateral to secure its exposure to the borrower in an amount acceptable to the lender and the rating agencies. In most cases, borrowers will choose either option (i) or (ii).

Since most caps are purchased through an auction process, a bid package is usually assembled for the bidders, which includes the agreed-upon terms of the interest rate cap, the timeline for which the auction must be completed, the assignment of interest rate cap protection agreement, and the form of confirmation. The confirmation describes the particulars of the transaction, such as the loan amount, payment dates, accrual periods and other pertinent dates, the rates, and other material items necessary to understand the parameters of the interest rate cap. It is important to review the confirmation and the bid package to ensure all terms are correct, and accurately reflect the terms of the transaction. At closing, the borrower will collaterally assign the interest rate cap agreement, which is additional collateral for the loan, and ensures the lender’s right to receive payments under the agreement.

While interest rate hedging takes many forms, interest rate caps are the most common derivative in mortgage financing. As we understand the process, we expect the market and traditional requirements to make implementation of this aspect of mortgage financing a smoother and simpler endeavor.